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Modeling Leadership

So leadership does seem to matter. But then, how do we incorporate into our political economy models?

The answer is not clear, mostly constituting an area for future research, though there are a few attempts.

One approach to this has been pioneered in organizational economics, for example by Benjamin Hermalin’s work, focuses on how leaders, such as top managers, can take actions to “lead by example” and to motivate other workers in the organization (e.g., work visibly hard on a project to signal the value of putting more effort for a specific project).

Roger Myerson’s work has pursued a different line, modeling leadership as a form of reputational equilibria (the leader builds a reputation for sticking to his word, for example).

Perhaps more important in political economy is the role of leaders in solving collective action problems and coordinating beliefs and behavior. There is much less on this.

One approach is developed by Daron and Matt Jackson. Leaders are those individuals whose actions are “prominent” meaning that they are seen by more agents and more precisely. In a dynamic coordination game, this creates an advantage. If an individual who is not prominent wishes to switch from the Pareto dominated equilibrium of the coordination game to the Pareto dominant one, she will rightly worry that others will not see her action or its signal or that the signal will not be sufficiently informative. The prominence of leaders enables them to circumvent this problem, enabling them to change the equilibrium if they want to.

There are several directions for extending this. First, rather than taking prominence as exogenous, one can try to endogenize prominence by the past actions of an individual. For example, Nelson Mandela became prominent because of his key role in the African National Congress’ struggle, his organizational efforts and then unwillingness to make a deal with the Apartheid regime.

Second, one can introduce similar ideas in the context of a game of collective action (rather than simply a game of coordination between two players). Then the role of leaders would become closer to that of “solving the collective action problem,” a hallmark of political leadership.

This work takes a first, and specific, step in thinking about the role of leadership as coordinating beliefs, but there are other possibilities. For example, leaders solve the collective action problem not because of their prominence, but by introducing new ideas (something we will discuss in later posts) or by more effectively communicating their actions or information (for example, by forming or exploiting their social networks). But these ideas have not yet been, at least to the best of our knowledge, systematically investigated.

Another important role of leaders, which has been investigated even less, is to form new coalitions. They may be able to solve again affecting beliefs or by exploiting their network of friends, followers and associates.


Does Leadership Matter?

In our last post, we introduced Nelson Mandela’s challenge to political economy: incorporate the role of leadership and ideas into our theoretical and empirical investigations.

This is a bit like world peace. Pretty much everybody is in favor of it — or at least says they are in favor of it. But few know how to achieve it.

Of course it’s easy to criticize existing approaches because they don’t have leadership and a role for ideas independent of interest. But that’s also a little cheap.

Though some would disagree, we believe firmly that economics — and more generally social science — makes progress by being much more specific about how certain social phenomena can be modeled formally; by deriving new insights and perspectives that would not have been obvious without doing this modeling work; by devising new ways of measurement corresponding to these new concepts; and by testing hypotheses and new ideas systematically using state-of-the-art econometric and statistical methods.

So the devil is in the details.

Be that as it may, there is actually work in political economy and economics in general on these topics.

First, two related strands of work show that leaders do indeed matter.

The first is exemplified by a creative paper by Benjamin Jones and Benjamin Olken, “Do Leaders Matter?”. Focusing on changes in national leadership resulting from random leader death (where leader here means the person with executive power which could be president, prime minister or dictator), Jones and Olken find evidence that leaders do matter.

In particular, they test for the hypothesis that the growth rate of GDP is the same before and after the random leader death, and comfortably reject this hypothesis, suggesting that there is a change in growth as leaders die and are replaced by new ones.

Two things are particularly interesting about this paper.

First, they are testing whether a change in leadership is associated with any change in growth — a hypothesis much weaker than a change in leadership from somebody with certain characteristics (say low education) to other characteristics (say high education) increasing economic growth. This is for good reason. There doesn’t seem to be as strong patterns when it comes to leader characteristics (but see this paper and this paper).

Second and more interestingly, Jones and Olken show that this result is driven by changes in leadership in countries with weak and non-democratic political institutions. This says that the change from George W. Bush to Barack Obama, important though it was for many things, should not have changed the US growth rate, which is plausible.

This makes a lot of sense at some level. Good — what we would call inclusive — political institutions will allow less discretion for politicians to pursue policies that would be disastrous, and hence gyrations of economic growth should also be more limited.

It also implies that if you believe — as we firmly do of course — that institutions are central for understanding economic performance, there is no conflict with this view and one that shows that leaders do matter: leaders function in a framework created by institutions and their impact very much depends on and is modulated by these institutions (though of course they may in turn also shape the evolution of institutions as we will discuss later).

The second is a related line of work investigating the impact of Chief Executive Officers (CEOs) on company performance. An important paper that is the precursor to Jones and Olken’s work is Marianne Bertrand and Antoinette Schoar’s paper on “Managing with Style” which uses a related but in some ways richer empirical design exploiting the fact that, differently from national leaders, CEOs manage several major companies during their careers (or work as other top managers in such companies, which Bertrand and Schoar also incorporate into their sample). Thus one can estimate an econometric specification in which company performance can be decomposed, among other things, into “CEO effects” and “firm effects” (formally, this means the estimation of a panel data regression in which there are both CEO and firm fixed effects).

Bertrand and Schoar also find that these CEO effects are statistically important — which is the equivalent of Jones and Olken’s finding that the hypothesis that growth before and after random leader death being equal can be rejected.

In addition, using the data available for practices under the reign of different CEOs, they can have a first attempt at investigating why different CEOs matter. In particular, they show that dividend policy, investment policy, cost-cutting strategies, financial policies and merger and acquisition decisions are particularly sensitive to who holds the reins of the company.

This conclusion is corroborated by more recent work by Nick Bloom and John Van Reenen which shows huge differences in management practices across and within countries, and provides evidence suggesting that these are likely to be quite important for firm performance.

These studies make considerable progress in showing that leadership at the company or the country level matters, and also putting some new ideas on the table related to in what ways leadership may matter.

Of course, there are many open questions. For example, at the national level, the death of a leader may matter not because of his character or vision, but because there are different “rent seeking coalitions” associated with different leaders (think of the rent seeking coalition in Egypt before and after Mubarak).

When one leader dies, this leads to the dissolution of one rent seeking coalition and the formation of another. This will naturally have an impact on economic performance even if the two rent seeking coalitions have exactly the same preferences over economic growth and investment in different sectors of the economy. Add to this the possibility that different rent seeking coalitions are supported by and will favor different businesses in sectors of the economy, it becomes quite possible that leadership transitions can be associated with very significant changes in economic growth without any of the notions about “leadership” we normally think about — particularly when being inspired by Nelson Mandela — being important.

At the company level, the same problem can occur, though this is easy to put to rest with the evidence that many important company practices do change significantly with leadership changes.

More important at the company level is the fact that leadership changes may be endogenous, partly occurring when the company already wants to change course in terms of some of these policies (this wasn’t as much of an issue at the country level because of Jones and Olken’s focus on random leader deaths).

Though there is probably some of this going on, it seems unlikely that the presence of this sort of endogenous CEO change by itself can explain all of Bertrand and Schoar’s results. Also, even if it could bias their point estimates, the qualitative results shouldn’t be affected, since the only reason why there would be a systematic change from one type of CEO to another when the company wants to change course is that some CEOs are better with or more likely to adopt some types of practices or will implement them more effectively, thus providing another type of support to importance of leadership.

This is of course just scratching the surface. Much more is needed to advance our understanding of how leadership matters at the national or the company level. We also need to study when there are leader transitions and also perhaps whether, when and how existing leaders change their strategies and approaches because of changing circumstances.

So there is much to be done here.

The same is true when it comes to the modeling of leadership, which we will discuss in our next post.


Nelson Mandela, Leadership and Ideas

Nelson Mandela, who passed away on December 5, 2013, was not just a great politician and an inspirational leader, but also constitutes  a challenge to our models of political economy. 

Models of political economy attempt to systematically study the distribution of political power in society and the resulting equilibrium policies and institutions. This typically proceeds by means of a game theoretic model in which different groups (which are implicitly or explicitly assumed to have solved their internal collective action problems) compete, negotiate or fight in order to get their way. Or individuals, who are assumed to have well-defined beliefs about policy preferences, vote or by other means support different parties, policies or institutions. In some models, which individuals and groups enter into a coalition with others is studied, while other approaches focus on political and economic conflict under incomplete information. 

But two things are generally missing in these models: leadership and ideas.

Leaders play little role in these models, and there is only a limited role for ideas (except through some Bayesian modeling of beliefs and perhaps experimentation).

But it is hard to understand Nelson Mandela’s huge impact on South African politics — and beyond — without incorporating leadership and ideas into our political economy paradigm.

Mandela showed great leadership in steering the anti-apartheid struggle, in negotiating the transition from apartheid to democracy, and then later in bringing about some partial reconciliation between black and white South Africans. 

Mandela was also so transformative for South African politics because he changed people’s ideas about what should be done and what could be done. He did this first in his fight against the apartheid regime, and then with his efforts to define South Africa as the “Rainbow Nation”. His “idea creation” perhaps gained its apogee when, as South Africa’s first black president, he presented the 1995 Rugby World Cup trophy to the South African national team, the Springboks, long identified with the apartheid regime, wearing their jersey, opening a new chapter in reconciliation between whites and blacks.

So let’s think of incorporating leadership and ideas into political economy as Nelson Mandela’s challenge. 

Can political economy rise up to this challenge?

In the next few posts, we will argue that the answer is yes, but with some work. 

For now, it is useful to note that these issues are not entirely absent in the political economy literature.

Mancur Olson in his seminal Logic of Collective Action already put leadership at the center of political economy, particularly with his discussion of “political entrepreneurs” as agents solving collective action problems.

Dani Rodrik has recently emphasized the importance of ideas and made a call for their systematic incorporation into political economy. 

But the devil is in the details. What is it exactly that leaders do? And what are ideas and in what way are they endogenous and manipulable by individuals, groups and institutions? 

These are the questions we have to ponder in order to come to grips with Nelson Mandela’s challenge.


David Cameron's Favorite Book


Value of Connections of the United States

It is well-known that who you know and who you are connected to matters greatly for your business success in many countries. This is nicely documented in several papers that show how connections to powerful politicians have a huge value in countries with weak institutions.

For example, in a famous paper Ray Fisman used an event study methodology exploiting rumors about the health of the Indonesian dictator President Suharto to show how close connections to Suharto were greatly valuable: these adverse news reduce the stock market value of the firms connected to him.

Similar results were found, among other places, in Malaysia by Simon Johnson and Todd Mitton and in Pakistan by Asim Khwaja and Atif Mian.

But the consensus view has been that such connections don’t matter in countries with strong institutions such as the United States.

In fact, Larry Summers used this as the basis for his argument for why the response to financial crises should be different in the United States in his Ely Lecture to the American Economic Association: strong US institutions imply that policies that should not be tried in Indonesia or Malaysia because of concerns about cronyism and corruption could be adopted with little worry in the United States.

This view was supported by work that applied similar methodology to the United States. For example, other work by Ray Fisman, together with co-authors, found that the value of connections to Dick Cheney were small or nonexistent.

So US institutions do seem to work as they are supposed to.

Recent work by Daron, Simon Johnson, Amir Kermani, James Kwak and Todd Mitton finds something quite different, however.

Focusing on the announcement of Timothy Geithner as President-elect Obama’s nominee for Treasury Secretary in November 2008, they report robust and large returns to financial firms with connections to Geithner. Connections here are defined either from Timothy Geithner’s meetings with financial firm executives during the previous two years when he was the President of the Federal Reserve Bank of New York, or from his overlap on non-profit boards with these executives. What’s going on?

One possibility is that this just reflects the fact that firms that had such connections are also those that would have actually benefited from the safe pair of hands that Timothy Geithner would bring to the job of Treasury Secretary. Though plausible, this explanation does not receive any support from the data:  controls for characteristics that could capture such benefits do not change the results, and in fact the results hold when comparing firms of very similar size, profitability and leverage, and similar risk and stock market return profiles.

Another possibility is that the same sort of shady dealings that went on in Indonesia, Malaysia or Pakistan are also present in the United States — or at the very least were thought to be present by stock market participants. But this seems very unlikely, and there is no evidence to support this. Timothy Geithner appears to be an honest technocrat, with no interest in doing favors in order to get campaign contributions or financial gain.

Instead, the paper suggests a different hypothesis: “social connections meets the crisis”.

Namely, the excess returns of connected firms may be a reflection of the perception of the market (and likely a correct perception) that during turbulent times there will be both heightened policy discretion and even more of the natural tendency of government officials and politicians to rely on the advice of a small network of confidants. For Timothy Geithner this meant relying on, and appointing to powerful positions, financial executives from the firms he was connected to and felt comfortable with. But then, there is no guarantee that these people would not give advice favoring their firms, knowingly or perhaps subconsciously (for example, they may be under the grips of a worldview that increases the perceived importance of their firm’s survival for the health of the US economy).

So Larry Summers is probably right that strong US institutions preclude the sort of dealings that went on in Indonesia under Suharto or in Malaysia under Mahathir Mohamad. But this does not mean that connections don’t matter or that we should not worry and be vigilant about them, particularly during turbulent times when important decisions have to be made quickly and the usual mechanisms for scrutinizing important policy decisions are weakened or suspended.

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